In a reversal from historical experience, Freddie Mac Gold PC securities have recently cheapened versus their Fannie Mae counterparts, which was caused initially by the release of the April prepayment report showing that the differential between Freddie and Fannie speeds was slightly greater than in previous months. Aside from this, analysts point to poor CMO creation due to the lack of outstanding current coupon mortgages.
At current interest rate levels, Golds should be selling over three to four ticks rich to Fannie securities, which compensates for the 10-day differential in the receipt of cash flows, stated a recent report from UBS Warburg. The firm explained that Freddie Golds pay on the 15th of the month (this reflects coupon and principal concentration from the previous month) - resulting in a 14-day delay in receiving payments.
In the meantime, UBS said Fannies securities pay on the 25th of the month, which also reflect coupon and principal paydowns from the prior month. So the actual delay of Fannie securities should be 24 days. The firm said that in order for the two securities to produce the same yield, prices on Gold securities must be higher. This is to make up for the fact that buysiders receive Freddie cash flows 10 days sooner and therefore profit earlier from reinvestment of those proceeds.
However, currently (using prices as of Monday, May 12, 2003) there are unfavorable spreads for Golds. For instance, UBS said that at present 30-year Gold 5s are selling a half tick lower in price compared to their Fannie counterparts. They explained that since the theoretical value of Golds is actually four ticks higher than Fannie counterparts, this would imply that Golds are over four ticks cheap to their theoretical value.
But despite the prepayment differential, UBS believes that Golds has become very cheap versus their Fannie counterparts, particularly in the 30-year sector, where UBS believes the Gold/Fannie differential have been priced to a worst case. In terms of 15-year product, Golds are considered cheap, but are not yet priced to a worst case.
"We believe a jittery market has overreacted to Fannie-Gold prepayment differentials," wrote analysts. "There is no question that Gold speeds are slightly faster than their Fannie counterparts, and that Gold securities held by investors are slightly faster than aggregate Gold speeds. However, investors have exaggerated both of those effects, courtesy of technical factors."
Dwindling CMO activity
David Montano, head of mortgage research at JPMorgan Securities, said that the primary reason why Golds are not doing well is servicer concentration. Historically, CMO arbitrage has helped boost Gold execution; however, CMO activity has slowed recently. "Gold CMOs are trading very poorly so there is very little arbitrage in Golds," said Montano. "If CMO activity were to pick up, then Golds could come back in the lower coupons."
Aside from this, the Street has a lot of Gold structured IOs on their inventories because majority of the CMOs have been done off of Golds. The Street is also bidding on large amounts of Gold IOs, making it more difficult to offer the paper. Montano said that another problem why there is not much activity in CMOs is that there is very little available in the Gold 5% coupon, which is the only Gold coupon where there is any arbitrage to be found. The flat curve is also not helping.
The 5.5% coupon and higher are not considered attractive for CMOs backed by Golds because there is too much IO collateral in them, and Gold IOs off of 5.5s are trading about two points cheaper compared to Fannie IOs. And even at 3.5 ticks behind Fannies in price, Gold 5.5s are not viewed as cheap enough. This is why for coupons 5.5% and higher, Montano said that they do not particularly like Golds. However, they consider the Gold 5% coupon attractive, which as of last Wednesday, was trading a tick behind Fannies. And if CMO activity picks up, this should trade better, and investors could get two or three ticks of upside.
A bigger concern for investors is probably the prepayment differential on the structured product that they own (i.e, CMOs and structured IOs and POs). For instance, Freddie 223 IOs, which is a security with a 6 WALA, prepaid at 29.7 CPR last month while a very similar security - Fannie 329 IOs - prepaid at 20.9 CPR. One effect of the resulting price difference between Gold and Fannie IOs is that it is more difficult to structure Gold-backed Remic deals, since the execution on the IO tranches is much worse for Freddie deals. The lack of a collateral bid, in turn, has diminished demand for Golds as deal collateral and been another factor in the sector's poor performance.
"People are starting to look at the securities they own, particularly the structured securities like CMOs, where the speed differentials between Gold and Fannie deals are quite significant," said an MBS analyst. "We think that is what is really scaring investors." He also mentioned there are other problems such as the fact that Freddie issuers Wells Fargo and ABN Amro are notoriously fast and the fact that the market for Gold passthroughs has been plagued with liquidity issues as the firm has been losing market share against Fannie Mae in terms of production numbers.
"I think there is a real problem with Golds in terms of speed expectations and in terms of liquidity so they are cheap and they should be cheap," said the analyst. "Right now with such elevated dollar prices - where even the handle on the 5.5% coupon is at 103 - the prepayment expectations on these bonds are becoming critical. So even if Golds are very cheap historically, the liquidity give-up and prepayment uncertainty do not make it worth the aggravation."
Meanwhile, Freddie released a statement to its PC Investors saying that the GSE "places the highest level of importance on the performance of our mortgage-backed securities and on investor satisfaction with all of our financing vehicles." Then added, "We are aware of marketplace concerns with regard to prepayment speeds on Freddie Mac Gold PCs. We are taking immediate action to achieve our corporate objective that prepayment experience on Freddie Mac PCs is consistent with market norms.
Freddie named three specific strategies to respond to these concerns. The first is the immediate development of contractual incentives and penalties around sellers' prepayment experience on outstanding and new PCs. The second is returning loan characteristics and seller/servicer diversity to more typical levels over the balance of the year, and the third is expanding REMIC opportunities for dealers and investors with removal allocations.
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